The trend path of output is the long-run path after short-run
fluctuations are ironed out. The business cycle describes fluctuations in
output around this trend. Cycles last about five years but are not perfectly
regular.
A political business cycle arises from government manipulation
of the economy to make things look good just before an election.
Persistence requires either sluggish adjustment or intertemporal
substitution. Persistence is necessary but not sufficient for cycles.
The multiplier–accelerator model assumes investment
depends on expected future profits, which reflect past output growth. The
model delivers a cycle but assumes that firms are stupid: their expectations
neglect the cycle implied by their own behaviour.
Full capacity and the impossibility of negative gross investment provide
ceilings and floors that limit the extent to which output
can fluctuate.
Fluctuations in stockbuilding are important in the business
cycle. The need to restore stocks to original levels explains why output continues
to differ from demand even during the recovery phase.
Real business cycles are cycles in potential output itself.
In such circumstances, it is not desirable for policy to dampen cycles.
Some swings in potential output do occur, but many short-run fluctuations
probably reflect Keynesian departures from potential output. Aggregate demand
and aggregate supply both contribute to the business cycle.
Increasing integration of world financial and product markets has made
most countries heavily dependent on the wider world. Business cycles in the
rich countries are closely correlated.
In 2001 central banks cut interest rates to prevent recession from spiralling.
Japan's difficulty escaping from the deflation trap suggests that dampening
business cycles remains an important aim for other countries.
